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PAYROLL TAX PROBLEMS

An employer is required to withhold federal income taxes, Social Security taxes and Medicare taxes from employees and to pay over such amounts to the IRS. These taxes are really employee monies and are withheld from the employee by the employer for payment over to the government. They are commonly referred to as "trust fund" taxes. In addition, the employer is also required to pay Social Security taxes and Medicare taxes of equivalent amounts to the government for each employee. These taxes will hereinafter be referred to as the "employee's share" (or trust fund taxes) and the "employer's share" of employment taxes.

Struggling businesses often fall behind in their bills. In order to continue in business, it is not uncommon for businesses to pay other creditors before the Internal Revenue Service. Individuals responsible for paying business bills may hope that by the time the IRS takes action, the business will have turned around and will have sufficient funds available to pay off all past due employment taxes.

What these individuals do not realize is that the person who makes the decision to favor business creditors in preference to the IRS, is generally held personally liable for some or all of these unpaid employment taxes.

In this regard, sole proprietorships and partnerships are treated differently than corporations. With regard to sole proprietorships and partnerships, the code and regulations clearly indicate that the individual responsible for payment of the employment taxes of the business will be personally liable for both the "employer's share" and "employee's share" of unpaid business employment taxes. Or, looking at it another way, that individual is personally responsible for all taxes, including penalties and interest, required to be reported by the business on Forms 941 and 940.

Responsible individuals and officers in corporations, on the other hand, are subject to a different set of statutory rules and regulations. Individuals who are responsible for paying corporate business creditors in preference to corporate federal employment taxes will be held liable under the "trust fund recovery penalty statute", but only to the extent of the "employee's share" of employment taxes. In other words, responsible individuals are only personally liable for unpaid corporate employment taxes to the extent of monies "withheld" from employees for Social Security, Medicare and federal income taxes, but not paid over to the IRS. They are not personally liable for the "employer's share" of Social Security Taxes and Medicare taxes.

In the "choice of entity" selection process in starting a new business, this is an often overlooked tax and business planning consideration. This issue is underscored by the fact that once an individual is held personally responsible under these rules, he will find that unpaid employment taxes are not dischargeable in a personal bankruptcy. Individual income taxes, on the other hand, under certain circumstances, are dischargeable in a Chapter 7 bankruptcy.

Generally, two conditions must be met in order to assess and collect the unpaid corporate employment taxes from an individual. These conditions are as follows:

1. The taxpayer must be a "responsible" person. The key to responsibility is the power to control the decision making process which results in the business paying its funds to other creditors in preference to paying its withholding tax obligations to the Internal Revenue Service.
   
   
2. The taxpayer's conduct must be willful. Inherent in the willfulness standard is the case law requirement that the responsible individual have knowledge of the non-payment of federal taxes. Unfortunately, the Internal Revenue Service has taken a very simplistic approach to willfulness. Generally if business bank records indicate that liabilities other than taxes were paid during the time of the accrual of the unpaid employment taxes, then the responsible person is automatically deemed willful. The IRS often uses signatures on employment tax returns as an indication of knowledge and willfulness. The signing of business checks is also used by the Internal Revenue Service to prove willfulness. A person's signature on an IRS payment plan for prior unpaid federal employment taxes guarantees that person will be held responsible under the trust fund penalty statute.

In the case of sole proprietorships and partnerships, the business owner and/or all general partners are held personally liable without the requirement for the IRS to meet the "responsible person" and "willfulness" standards. These liabilities are statutory in nature and liabilities are automatically assessed.

Prior to the enactment of the IRS Restructuring and Reform Act of 1998, taxpayers had no clear rights when the IRS proposed the assessment of the trust fund recovery penalty against the taxpayer. Taxpayers and tax practitioners could fight administratively within the Internal Revenue Service, but historically the results of the IRS fight were unfavorable. Essentially the IRS made its own rules. The IRS was not subject to judicial review (review by a party outside of the agency) except in a very narrow sense. A taxpayer could undertake complex and expensive refund litigation by suing the Internal Revenue Service in United States District Court in the district of their residence. This was rarely done and taxpayers found themselves essentially at the mercy of the IRS' interpretation of personal liability for unpaid employment taxes. The IRS often took a shotgun approach and freely assessed personal liability, often times on multiple parties.

1998 TAX LEGISLATION - NOTICE OF TRUST FUND RECOVERY PENALTY

The IRS Restructuring and Reform Act of 1998 brought in sweeping changes in taxpayer's rights with regard to trust fund recovery penalty matters. As it stands now, the IRS cannot assess the trust fund recovery penalty against "responsible corporate officers" without sending a preliminary notice informing the individual taxpayer of the proposed penalty. What does this all mean to the unfortunate client who finds himself involved in trust fund recovery penalty issues?

At least 30 days prior to assessment, the IRS must notify the taxpayer in writing of their right to a hearing. Clients now can, and routinely do, request that hearing. With the hearing, the client is given the right to have the matter heard by an independent Appeals Officer. While still an Internal Revenue Service employee, the Appeals Officer is now prohibited from having any pre-hearing conferences with the IRS Revenue Officer who is responsible for the proposed trust fund recovery penalty. Prior to the new legislation, many Appeals Officers, in conference with the assigned Revenue Officer, were predisposed to find for a tax assessment. At the current time, however, Appeals Officers are acting with greater independence and are taking into consideration a wide range of issues ranging from the validity of the underlying assessment to resolution by Offer in Compromise.

And, if the client is not satisfied with the Appellate Conferee's decision, the client need not give up. The taxpayer then has 30 days after the appeals hearing determination to appeal the determination in the U S Tax Court. New in 1998 is Tax Court jurisdiction over trust fund recovery issues.

These new due process provisions have the practical effect of allowing clients to prevail over the IRS in those instances when personal responsibility is not clear. Prior to the Act, the IRS asserted the penalty and was not generally subject to judicial review. Currently taxpayers' arguments as to lack of knowledge and lack of willfulness are carefully considered.

These due process provisions are truly revolutionary. They can tie the IRS hands for months and perhaps years. Congress did, however, take taxpayer delay tactics into consideration in 1998. The statute of limitations for assessment, collection and criminal investigations will all be tolled pending the administrative and judicial review of these cases. Therefore, a frivolous fight by a client will only serve to delay the inevitable and invite professional fees from tax practitioners. Interest on the trust fund recovery penalty assessment, however, does not begin to run until the actual assessment is in place. Even if the taxpayer loses in a non-frivolous fight with the Internal Revenue Service, he will have succeeded in delaying the assessment and the starting point for the accrual of interest on that assessment.